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PR09/10

TO ALL RDs OF WATER ONLY COMPANIES
AND WATER & SEWERAGE COMPANIES

If the large user threshold falls, revenue will be excluded from the tariff basket. We will project the revenue that is excluded for future years based on the expected changes in revenue from all groups of customers that are newly excluded from the tariff basket either in part or in whole. We will then deflate the revenue to 2007-08 prices using financial year average RPI and deduct it from our expectation, ie step 1 in Part A.

Please see Annex B for a worked example.

-Further guidance on when to exclude large user revenue

Revenues are excluded from the tariff basket if they are from charges for supplies of water to premises where the premises were supplied in the weighting year with not less than 50 Ml per year in England and 250 Ml per year in Wales.

We require companies to make this assessment at the end of the weighting year in order to report June return information and submit Regulatory Accounts. Companies might not have complete information at this time and, consequently, might include or exclude revenues mistakenly. However, if a company makes this judgement based on best available knowledge, it should adhere to it and subsequently use it for the purposes of preparing its principal statement. Otherwise we will expect companies to revise June return figures when errors become apparent and use this revised view as the basis for the principal statement.

-Reporting requirements

In PR09/07 we consulted on the PR09 business plan information requirements and set out our expectation that we would need a large amount of information on non-households to be able to keep track of movements in or out of the tariff basket. We now believe that the above approach will not require as much information. Companies will be able to choose the thresholds that they report, although as a minimum all companies must separate tariff basket and non-tariff basket revenue. We will still require each company to report revenue separately for potable water, non-potable water, sewerage, and trade effluent, but it can use different thresholds in each case.

Part C - Tax

When we calculate the revenue correction we will take into account changes in each company's tax arising from changes in revenue. We will adjust the amount of revenue correction required using the marginal rate of corporation tax.

Please see Annex C for a worked example.

Some companies have queried a potential conflict between turnover reported under UK GAAP and our proposed revenue correction mechanism. Please see RD05/08, which we will publish shortly, for an explanation of how this should be treated for regulatory purposes.

Part D - Billing incentive

Existing customers benefit when companies bill all properties that receive a water or sewerage service because companies' costs are recovered from the largest possible number of customers, which acts to reduce average bills.

The revenue correction will include an adjustment to incentivise companies to maintain accurate billing records. Otherwise in the long term companies would accrue the same revenue no matter how many properties they billed. We want the billing adjustment to:

1. Provide companies with an incentive to find and bill additional properties as soon as possible because the extra revenue will be passed on to customers at the next review as part of the revenue correction mechanism. To do this the incentive must be greater if a company finds and bills additional properties throughout the period, than if it finds and bills the same properties at the end of the period.
2. Provide incentives that do not exceed the benefit that consumers receive.
3. For companies to have incentives to bill additional properties throughout the period. Without this a company might choose to make an effort only at the start of a price review period. Thereafter it might relax its efforts on the basis that this will lead to higher price limits at the next periodic review.

At PR09 we will set out our expectation of the number of properties that companies will bill each year. To satisfy the first aim above we will adjust the correction each year for every property that the company bills above or below our expectation. We will set the adjustment - the "efficient billing factor" – at PR09, basing it on the cost that an efficient company incurs in finding and billing an additional property. We will calculate the amount that an efficient company incurs from information that companies provide in draft business plans. We will add to this an amount to act as an incentive.

To satisfy the second aim we will only count properties which have an annual bill that is above the efficient billing factor. For this reason companies will have to report information so that we can calculate the number of properties for which billing commences from April 2010 and for which the amount billed in the report year and contributing to revenue is more than the efficient billing factor.

Without further adjustment, if a company continues each year to bill a property that it first bills in 2010-11, then, all other things being equal, the company will receive five times more through the billing adjustment than it would receive for a property that it first bills in 2014-15. Therefore to satisfy the third aim we will make an additional adjustment for years 2, 3 and 4 of an AMP if a company manages to increase the number of properties it bills relative to our assumptions. The adjustment will be a proportion of the efficient billing factor, which we will specify for each year, applied to the additional outperformance. This will provide a reward for companies that continue to be active in finding and billing new properties. We will not incentivise additional outperformance for year 5 because we would not be able to pass the benefits on to consumers at PR14.

The third aim might not be consistent with the second aim if the extra incentive to exceed previous outperformance meant that total incentives exceeded the benefit to customers generally from billing more customers. But this would only be the case if all the extra properties that a company identified had bills that were close to the efficient billing factor. We think that the potential benefit of companies having a continuous incentive to outperform outweighs this small risk of incentives to companies exceeding benefits to customers. We will select proportions to apply to outperformance for years 2, 3 and 4 that minimise this risk.

Please see Annex D for a worked example.

-Factors not covered by the billing adjustment

This billing adjustment will not in itself provide an incentive for companies to bill customers accurately. We believe that companies already have an incentive to do this. If companies do not bill customers accurately, this leads to a higher number of customer contacts and complaints. In turn, this increases a company's operating costs and damages its reputation. If evidence suggested that a company was not taking reasonable steps to bill customers accurately, we would take appropriate measures to rectify the situation.

The revenue correction mechanism will reduce the incentive for companies to maintain and replace water meters so that they continue to measure water accurately for billing purposes. However, even now the cost of replacing a meter is likely to outweigh the increase in revenue that companies gain when they tackle under registration by maintaining or replacing meters. We will continue to monitor to make sure that companies maintain their assets, including water meters, and we will take regulatory action if we believe that companies are failing to do this efficiently. In the case of water meters, companies also have a duty to promote water efficiency which includes providing consumers with an accurate picture of their water demand.

We hope you find this information useful. If you have any questions or observations please contact Peter Jordan by telephone, 0121 625 1312 or by email peter.jordan@ofwat.gsi.gov.uk.

Yours sincerely

Paul Hope
Interim Director – Network Regulation